For example, the scientific approach to an orderly classification of plants
and animals according to their presumed natural relationships is called
taxonomy.1
Remember middle school science classes? Animals (including humans) are
classified by kingdom, phylum, class, order, family, genus, and
species.2 Oh, you were sick that day? Well, the
point is this—classifying or grouping is very common and is an important aspect
of the Insurance Services Office, Inc. (ISO), commercial general liability
(CGL) policy.
Purpose of the ISO CGL Classifications
Rule 25 of the ISO Commercial Lines Manual (CLM) is titled
"Classifications," and it very succinctly describes the purpose of
the classification system: "to group insureds into classifications so that
the rate for each classification reflects the hazards
common to those insureds [emphasis added]."
This is actually another way to describe the prime goal of the underwriting
process—to match the hazard or exposure of an insured with the appropriate
premium for that insured. In other words, at the foundation of the underwriting
process is the accurate classification of an insured to make sure the premium
matches the exposure. Failure to use the appropriate classification results in
a premium that is either too high or too low for that insured, leaving the
insurer with a premium that is not competitive (when the premium is too high)
or resulting in an underwriting loss (when premium is too low).
A Word on "Rates"
ISO does not actually publish "rates" for its member companies to
use but rather publishes "loss costs" by classification. Loss costs
are the portion of the premium intended to cover losses only—to calculate the
full "rate" for each classification, the insurer must add to the loss
costs its own costs of overhead.
To arrive at the final "rate," each insurer must increase ISO loss
costs by a "loss cost multiplier"—a factor that needs (in most cases)
to be filed and approved by each state's insurance department, as it
increases ISO's loss costs by the insurer's overhead costs. Loss cost
multiplier factors do vary by insurer, although usually not dramatically.
Applying the CGL Classification System
The ISO classification system starts with a 5-digit code that describes
the industry of the insured—Manufacturing or Processing (Codes 50000
to 59999), Contracting or Servicing (90000 to 99999), Mercantile (10000 to
19999), Building or Premises—office or space leased to others (60000 to 69999),
and Miscellaneous (40000 to 49999).
Stated differently, the 5-digit code included on all ISO classifications
first tells the insured how the insurer views them in a general manner—that is,
whether the insurer considers the insured to be engaged in manufacturing or
processing, contracting or servicing, mercantile, etc.
Premium Basis
Each general classification described above has a different premium basis.
For example, the premium for manufacturing or processing is developed by
applying the rate to gross sales (the rate is per $1,000 of gross sales),
contracting or services by applying the rate to payroll (the rate is per $1,000
of payroll), mercantile by applying the rate to gross sales (the rate is per
$1,000 of gross sales), building or premises by applying the rate to area (per
1,000 square feet) or units, and miscellaneous is varied.
And, of course, there are certain classifications that use other premium
bases. Two examples are "admissions," which include the total number
of people admitted to an event, and "total cost," which is the cost
of the work that is subcontracted to others using a rate per $1,000 of total
costs.
Classification Descriptions
Each classification within the general industry classifications noted above
also includes a written description of the classification. For example, a
manufacturer's CGL policy declarations may include the following.
51370 Bicycle Mfg.—Not Motorized—$10 Million Gross Sales
As may be inferred from the classification description used in this example,
this classification applies only to a manufacturer making nonmotorized
bicycles. If this insured also made mopeds or motorized scooters with gross
sales of an additional $5 million per year, a separate classification
should be included on this insured's CGL policy.
57202 Motorcycle, Moped, or Motor Scooter Mfg.—$5 million Gross Sales
In other words, more than one classification may be added for one
business that has separate operations—as this is consistent with matching
the premium with the exposure.
ISO Classifications—Effect on Coverage
The classification code or class description generally does not have any
effect on the coverage afforded by the ISO CGL policy. That is because the
classification system is only for the purposes of matching premiums with
exposures. More importantly, the insuring agreement, exclusions, limitations,
or conditions of an unendorsed ISO CGL policy are usually not changed
in any way by the classification code or description. But there are important
exceptions.
Missing Classifications
It is often wrongly assumed that no coverage applies if the policy does not
include a certain classification code and description. This view is usually
because the legal remedy available for material misrepresentation by an
insured—which is rescission of the policy—is confused with the overall purpose
of classification, which is to match exposure with the premium charged for the
insured's business. Certainly, a missing classification may be evidence
that the named insured failed to disclose at policy inception all of its
operations—which later may result in a rescission action by the insurer.
There is, however, no limitation in an unendorsed ISO CGL
policy's insuring agreement, exclusions, limitations, or conditions that
states that coverage applies only to those operations or activities that fall
within the classification code and description.
A double-edged sword. Given the above, underwriters for
insurers should understand that the classifications—descriptions and codes—may
also undermine or even void entirely an insurer's later attempts to apply
certain exclusions in the unendorsed ISO CGL policy.
First, consider the representations condition of the CGL
policy.3 The named insured and the insurer
agree that the statements on the declarations are accurate and complete and
that the statements are based on representations of the named insured and the
policy was issued based on the insurer's reliance on such
representations.
Second, consider (for example) the liquor liability exclusion (exclusion c.)
of the unendorsed CGL policy—the exclusion only applies if the named insured is
"in the business" of furnishing or selling alcohol.
Here is the "double-edged sword": if the insurer has consistently
and accurately classified and described the named insured as, for
example, a Shoe Repair Shop 18109, the insurer cannot contend at the time of a
claim that the named insured was "in the business" of selling or
furnishing alcohol. In other words, as the insurer has already agreed, as a
condition of the CGL policy, that the named insured was in the shoe repair
business, the insurer cannot at the time of a claim assert that, contrary
to the insurer's prior agreement, the liquor liability exclusion
applies as the named insured was actually in the business of selling or
furnishing alcohol.
To the extent that exclusions apply only when the named insured is "in
the business" or "whose business is" (such as the Coverage B
exclusion for an insured "whose business is … advertising, broadcasting,
publishing, or telecasting"), the classifications descriptions and codes
selected by the underwriters may constitute the agreement—pursuant to the
Representations condition—that the insurer had with the named insured and
prevent the insurer from reneging on that agreement to avoid coverage.
The Challenge of Classifications
Properly classifying all of the business operations of an insured is no easy
task. A great deal of underwriting judgment may be required. And, it should go
without saying that every business does not fall fully or completely within a
classification or classifications.
In how to assign classifications, the ISO CLM seems to implicitly
recognize this fact. CLM Rule 25.C directs the user to "… choose
the classification from section of the Manual which best
describes the operation." [Emphasis added.] Of course, there is room
for disagreement—but any such disagreement should not be grounds for seeking to
deny coverage.
Role of Premium Audit
Most CGL policies are subject to premium audit, which gives the insurer an
opportunity to "compute all premiums for this Coverage Part in accordance
with our rules and rates." So, if the insurer is following ISO, its rules
are the ISO CLM rules, including Rule 25 Classifications, which would
permit a better or an additional classification to be added, if
warranted—including retrospectively for that policy period.
In our example of the bicycle and moped manufacturer, presume that the
business decided during the policy period to open a wholesale-type outlet that
sold its bicycles directly to the public, including offering servicing of those
bicycles sold. The classification that best describes this operation is a
mercantile classification.
10150 Bicycle Stores—Sales and Servicing
Certainly, the insurer would want to know about the sale of bicycles, but
failing to immediately add the classification code and description would not
exclude from the insured's CGL coverage any claims related to the bicycle
sales or servicing operations. On the other hand, the insurer would be
justified at the time of premium audit to add the bicycle sales classification,
including the gross sales reported on this new operation, and charge based on
the gross sales from the date the operation began.
ISO Classifications—Effect on Coverage—Exceptions
Following are some exceptions to the ISO classifications and their effect on
coverage.
Classification limitation endorsement. Some surplus lines
(nonadmitted) insurers use a non-ISO endorsement titled "classification
limitation endorsement." This endorsement essentially adds an
exclusion to the CGL policy. The insuring agreement no longer applies to
the following.
"… bodily injury," "property damage," "personal
injury" or "advertising injury" arising out of any
classification(s) which is (are) not scheduled in the Commercial General
Liability Coverage Part Declarations and for which you have not paid a
premium.4
In our previous example as respects the bicycle manufacturer, if its CGL
policy included this classification limitation endorsement, all coverage would
have been excluded for the bicycle sales and services, as the proper
classification on the CGL policy was not scheduled. Coverage would not have
been provided unless and until the bicycle sales and services classification
was added to the CGL policy with a corresponding premium charge.
This endorsement may be very onerous to the insured—as all of its operations
may not fall neatly into a classification description, a substantial amount of
uncertainty is introduced as to whether the CGL policy will provide any
coverage. Even the most experienced insurance underwriters are not always
absolutely positive as to exactly which operations or activities are
included within any particular classification code and description. Possibly
more importantly, how is the insured to understand the scope of the coverage
provided? Most policyholders do not have access to the CLM or other
underwriting aides used to determine the exposures included and not included
within any particular set of classifications listed on their CGL policy.
Consider this real-life example. A landlord with a similar classification
limitation endorsement was sued for its alleged failure to protect patrons of
the tenant. Did the "lessors risk only" classification description
include this potential exposure of the landlord? There was considerable doubt.
Coverage was resolved against the landlord but based on a different CGL
exclusion—an assault and battery exclusion.
Other Exceptions—ISO
Endorsements required by the CLM. Certain ISO
classifications found in the CLM require the attachment of
endorsements that change the scope of coverage in the CGL policy. For example,
the ISO Classification Fuel Oil or Kerosene Dealers 13204 directs the
underwriter to exclude failure to supply by the attachment of
endorsement CG 22 50. However, unlike the classification limitation
endorsement, if the insurer has filed or otherwise elects not to attach the
"Exclusion—Failure to Supply" via CG 22 50, the CGL insuring
agreement is not changed by the classification code and the description alone.
Thus, the insured would not be subject to the failure to supply the
exclusion.
Certain ISO classifications may also add to or at least
clarify the coverage in the CGL policy. An example is the ISO
Classification Snow and Ice Removal—Contractor 99310. This classification
description in the CLM directs the underwriter to use the endorsement
Snowplowing Operations Coverage Endorsement CG 22 92. The effect of the CG 22
92 is to expressly state that exclusion g. of the CGL (the auto exclusion)
does not apply to any auto used for snow plowing operations for bodily
injury or property damage that falls within the products-completed
operations hazard.
Contractors that regularly perform snow removal for others may fail to
disclose this operation in a misguided attempt to save on premium. The result
may be the contractor would have no coverage in either the auto or CGL policy
for the typical slip and fall at a customer's premises that takes place a
few days after the snow removal was completed. This potential gap in coverage
may be resolved by full disclosure of the snow and ice operations—allowing the
underwriter to assign the proper classification, which includes adding coverage
in the CGL via the Snowplowing Operations Coverage Endorsement CG 22 92.
Limits
Other classifications change how the CGL limits may apply. For example, many
classifications state that the "Products/Completed Operations are
included," referencing the CGL definition of "Products-Completed
Operations Hazard," specifically that the "Products or operations for
which the classification, listed in the Declarations … states that
products-completed operations are subject to the general aggregate
limit."
The "Products/Completed Operations are included" wording is
included in the classification for bicycle rentals.
10151 Bicycles—Rented to Others
Products/Completed Operations are included
So, even if the above bicycle rental shop does have an incidental product or
completed operations exposure (such as occasionally adjusting the brakes on a
bicycle owned by a good customer), any resulting bodily injury or property
damage is still covered by the CGL policy—but all claims are subject
to the general aggregate limit and not the separate products-completed
operations aggregate limit.
Conclusion
The overall purpose of the ISO Classification System used with the ISO CGL
policy is to match the exposure with the premium. By grouping like businesses
with like exposures, ISO is able to develop loss costs that allow the matching
of exposures with premiums. However, it should be recognized that classifying
businesses for the purpose of a CGL policy is more art than science, requiring
judgments by underwriters as to the classification that best describes
the operations of an insured.
As a general matter, the ISO classification codes and descriptions do
not restrict the CGL coverage. Coverage in a CGL policy is restricted only
by actually changing the insuring agreement, exclusions, limitations, or
conditions—and the classifications (but with the important exceptions more
fully described above) do not change any of the CGL policy
wording.
Finally, classification limitations endorsements are particularly onerous in
that coverage is restricted (due to adding exclusionary wording to the CGL
policy), but exactly how the restriction will apply is not usually known until
after a claim—when a determination is made as to the exposures the insurer
asserts are and are not included within a particular classification code and
description.
Craig F. Stanovich, CPCU, CIC, CRM,
AU, is cofounder and principal of Austin & Stanovich Risk Managers LLC, a
risk management and insurance advisory consulting firm specializing in all
aspects of commercial insurance and risk management, providing risk management
and insurance solutions, not insurance sales. Services include fee-based
"rent-a-risk manager" outsourcing, expert witness and litigation
support, and technical/educational support to insurance companies, agents, and
brokers.